Chapter 8 Flashcards
What is the financial system?
The financial system consists of institutions that help match one personβs saving with another personβs investment.
What are financial markets? Name two examples.
Financial markets are institutions through which savers directly provide funds to borrowers.
Examples:
Bond Market: A bond is a certificate of indebtedness.
Stock Market: A stock is a claim to partial ownership in a firm.
What are financial intermediaries? Name two examples.
Financial intermediaries are institutions through which savers can indirectly provide funds to borrowers.
Examples:
Banks: Accept deposits and make loans.
Mutual Funds: Pool funds from individuals to invest in a diversified portfolio.
Define national saving (S).
National saving is the total income in the economy that remains after paying for consumption and government purchases:
π=πβπΆβπΊ
Where π is GDP, πΆ is consumption, and πΊ is government spending.
What are private and public saving?
Private Saving: Income remaining after households pay taxes and consumption:
π_private=πβπβπΆ
Public Saving: Tax revenue remaining after government spending:
π_public=πβπΊ.
What is the equation for national saving in terms of private and public saving?
π=π_private+π_public.
What is the market for loanable funds?
The market where savers supply funds for borrowers to invest. The interest rate is the price of borrowing.
What is the impact of a government budget deficit on the loanable funds market?
A budget deficit reduces public saving, shifting the supply curve for loanable funds to the left.
This raises the interest rate and decreases investment.
What is the formula for investment in a closed economy?
πΌ=πβπΆβπΊ
In a closed economy, πΌ=π.
What are the characteristics of a bond?
Term: Length of time until maturity.
Credit Risk: Probability of default.
Tax Treatment: How tax laws treat interest income.
What is the effect of an investment tax credit?
Shifts the demand curve for loanable funds to the right.
Increases the interest rate and encourages investment.
Define crowding out.
Crowding out occurs when increased government borrowing reduces investment due to higher interest rates.
What is the vicious cycle related to budget deficits?
Budget deficits reduce saving, increase interest rates, lower investment, and slow economic growth, which leads to further deficits.
What is the difference between equity financing and debt financing?
Equity Financing: Raising funds by selling stocks.
Debt Financing: Raising funds by issuing bonds.
What is the real interest rate? How is it calculated?
The real interest rate adjusts the nominal rate for inflation:
π=πβπ
Where π is the real interest rate, π is the nominal rate, and π is the inflation rate.
How is the interest rate determined in the market for loanable funds?
By the intersection of the supply and demand for loanable funds.
Supply: Comes from savers.
Demand: Comes from borrowers.
How do saving incentives affect the loanable funds market?
Increase the supply of loanable funds.
Shift the supply curve to the right.
Lower the equilibrium interest rate and increase investment.
What is the impact of taxes on saving?
Lower taxes on saving increase the supply of loanable funds, encouraging more saving and investment.
Calculate private saving given GDP = $2000, Taxes = $400, Consumption = $1400.
π_private=πβπβπΆ=2000β400β1400=200.
What happens to saving and investment in an open economy?
In an open economy:
π+(πΌπβπΈπ)=πΌ
Where πΌπ is imports, and πΈπ is exports.
Explain the relationship between risk and interest rates.
Riskier bonds pay higher interest rates to compensate for the increased likelihood of default.
Define a budget surplus and a budget deficit.
Budget Surplus: π>πΊ.
Budget Deficit: π<πΊ.
